India UAE Local Currency Settlement System – A Landmark Shift Towards De-dollarization

India UAE Local Currency Settlement System

A landmark event took place on 14th August, 2023, with the first-ever crude oil transaction being settled using the newly implemented Local Currency Settlement (LCS) system between India and the UAE.

The historic transaction involved Abu Dhabi National Oil Company (ADNOC) selling 1 million barrels of crude oil to Indian Oil Corporation Limited (IOCL), with payments being made in both Indian Rupees and UAE Dirhams rather than involving an intermediary currency.

This represented a major milestone for the recently introduced LCS system that allows direct settlement of bilateral transactions between India and the UAE in their respective local currencies.

The new rupee-dirham India UAE Local Currency Settlement System is an innovative mechanism to settle bilateral trade in local currencies, reducing transaction costs and promoting stability. Learn about its features, benefits, progress so far, and future impact.

India-UAE LCS Overview
India-UAE Local Currency Settlement (LCS) System
AspectDetails
Introduction Long history of bilateral relations since 1972
Bilateral trade at $85 billion in 2022 making UAE 3rd largest partner
Local Currency Settlement System MoU signed July 2022 during Modi visit to UAE
Settlements directly in INR and AED without need for intermediary currency
Key Features Removes additional conversion costs and delays through 3rd currency
Settlement in INR-AED faster and cheaper compared to USD
Expected to boost trade under CEPA and investment flows
Pool of local currency liquidity available for deployment in partner assets
Mitigates exchange rate risks and volatility for trade and remittances
Provides stability and insulation from global currency fluctuations
Progress So Far First transaction in July 2022 – 25 kg gold trade worth Rs 128 crore
Followed by INR payment to ADNOC for 1 million barrels crude oil in August
Benefits to India Aligns with policy to promote rupee trade and reduce USD demand
Conserves India’s dollar reserves and avoids currency conversion costs
Insulates India’s critical imports and economy from volatility
Promotes macroeconomic stability
Challenges Need to boost rupee’s limited global acceptability currently
Managing trade deficit through export promotion and import rationalization
Conclusion Pioneer for de-dollarization of bilateral trade with key partner
Can inspire similar local currency settlement systems with other nations

The Local Currency Settlement (LCS) system between India and the United Arab Emirates (UAE) has gained significant attention due to its potential for facilitating bilateral trade and investment.

This article aims to provide an objective overview of the LCS system, highlighting its purpose, features, and benefits.

Introduction

The strong economic ties between the two nations, characterized by a comprehensive strategic partnership and a robust trade relationship, provide a solid foundation for exploring innovative mechanisms to facilitate trade.

Bilateral trade between India and the UAE has witnessed significant growth in recent years, with the UAE emerging as one of India’s top trading partners globally. Additionally, the UAE is an important supplier of crude oil and petroleum products to India, while also being a major importer of food products from India. Furthermore, both countries have seen substantial investments in each other’s economies across various sectors.

Given such favorable conditions, the introduction of a local currency settlement system can potentially streamline transactions and promote greater economic integration between India and the UAE.

What is the Local Currency Settlement (LCS) system

  • Mechanism to promote use of INR and AED for cross-border transactions
  • Covers current account and permitted capital account transactions

The Local Currency Settlement (LCS) system between India and the UAE holds significant potential for reducing transaction costs and time in cross-border transactions.

By enabling invoicing and payment in local currencies, the India UAE Local Currency Settlement System (LCS system) eliminates the need for a third intermediary currency like the US Dollar, thereby streamlining the settlement process.

This has implications for enhanced trade and investment opportunities as well as financial stability between the two countries.

India UAE Local Currency Settlement System
India UAE Local Currency Settlement System (LCS system)

Key Features

Reduced Transaction Costs and Time

  • Removes need for third currency intermediation
  • Faster settlement compared to USD

By allowing direct settlement in local currencies, the LCS system significantly reduces transaction costs and time. Previously, when settlements between India and the UAE were conducted, a third intermediary currency like the US Dollar had to be used. This necessitated double conversion of currencies, resulting in extra foreign exchange costs and settlement delays.

However, with India UAE Local Currency Settlement System (LCS system) facilitating direct settlement in INR and AED, these additional costs and delays are eliminated. Transactions now travel directly between the transacting banks/authorities in India and UAE via their local clearing systems, without the need for correspondence banking through a third country.

As a result, the absence of double conversion saves on currency conversion charges and makes the settlement process faster and cheaper for all parties involved.

Enhanced Trade and Investment

Enhanced trade and investment opportunities can arise from the implementation of the Local Currency Settlement system between India and the UAE.

The reduction in transaction friction and currency volatility risks provided by this system creates an enabling framework for increased bilateral trade in goods and services. Moreover, it amplifies the preferential terms already agreed under the India-UAE Comprehensive Economic Partnership Agreement (CEPA).

Through settlement in local currencies, the LCS route supports the objective of reducing tariffs and duties to expand trade flows. Additionally, this framework is anticipated to spur two-way investment flows. By providing access to surplus liquidity in local currencies, it incentivizes Indian and Emirati entities to invest more as currency fluctuation risks are minimized.

Financial Stability

  • Mitigates exchange rate volatility risks
  • Local currency surplus can be invested in bonds, securities

Financial stability can be enhanced through the implementation of the LCS framework. It reduces exposure to exchange rate fluctuations and provides avenues for productive utilization of surplus liquidity.

The settlement of trade transactions in local currencies, such as INR and AED, mitigates the risks associated with routing payments through a third currency like USD. This approach confers greater stability and insulation from global currency volatilities.

In addition to mitigating currency volatility, the India UAE Local Currency Settlement System (LCS system) also creates opportunities for entities to invest their excess local currency balances in other local assets, such as bonds, securities, or equities of the partner country. This not only adds another layer of stability but also allows for the productive utilization of surpluses instead of exposing them to currency risks.

Thus, by reducing exposure to exchange rate fluctuations and providing avenues for surplus liquidity utilization, the LCS framework contributes significantly to financial stability in trade and investments between India and the UAE.

Progress So Far

  • First major transaction in July 2022 – Gold trade
  • Followed by oil trade transaction in August 2022 between IOCL and ADNOC

The progress made so far in the implementation of the Local Currency Settlement (LCS) system highlights several key points.

Firstly, it demonstrates the potential for rupee internationalization and reduced demand for USD in bilateral trade transactions.

Secondly, the India UAE Local Currency Settlement System (LCS system) provides protection from currency volatility by allowing transactions to be settled in local currencies, reducing exchange rate risks.

However, limited rupee acceptability globally remains a challenge that needs to be overcome for wider adoption of the LCS system.

Additionally, managing India’s trade deficit is crucial as the LCS expands its usage and settles a significant portion of bilateral trade in national currencies.

Benefits for India

Rupee internationalization and reduced USD demand

By settling trade in INR instead of USD, the Local Currency Settlement system for India facilitates the internationalization of the Indian rupee and mitigates the demand for US Dollars. This mechanism aligns with India’s policy efforts to expand the use of its currency in global trade and reduce transaction reliance on the US Dollar.

The India UAE Local Currency Settlement System (LCS system) enables India to pay for its substantial imports from UAE directly in INR, avoiding dollar payments routed through foreign banks. As a result, this will gradually boost direct demand for the Indian rupee globally.

Moreover, this system sets an important precedent for New Delhi’s future trade relationships with other partners as well, as it seeks to increase the usage of its own currency for cross-border transactions rather than intermediate dollars.

Protection from currency volatility

Protection from currency volatility is a significant advantage offered by the Local Currency Settlement (LCS) system. It shields against fluctuations in exchange rates and their potential impact on imports and external debt servicing.

With the India UAE Local Currency Settlement System, India can avoid exposure to changes in the value of the US Dollar, which is particularly important considering its role as a global reserve currency. Fluctuations in the dollar’s value can have profound effects on India’s economy, especially in terms of imports and external debt payments.

By promoting the use of local currencies such as the Indian Rupee for trade with countries like the UAE, the LCS system insulates India’s economy from global currency swings. This provides greater stability and insulation for critical imports such as crude oil and other commodities.

Challenges

  • Limited rupee acceptability globally
  • India’s trade deficit needs to be managed

Limited rupee acceptability globally

Limited acceptability of the Indian rupee globally poses a challenge for the success of the LCS framework. The current status of the Indian rupee in global trade and finance falls short compared to reserve currencies such as the US dollar and Euro. This limited acceptance hinders the effectiveness of the LCS system, as it relies on widespread use and recognition of local currencies.

To address this issue, efforts must be made to boost rupee acceptance on a global scale. This can be achieved through various means, such as promoting financial market reforms, enhancing economic stability, and increasing trade relationships with other countries.

India’s trade deficit needs to be managed

The trade deficit between India and the UAE needs to be prudently managed through careful strategies. One possible approach could be to focus on promoting exports by providing incentives to domestic industries, improving competitiveness in international markets, and diversifying export destinations.

Additionally, efforts should be made to reduce non-essential imports by prioritizing domestic production of goods that can substitute imported products. This could involve investing in research and development to enhance technological capabilities and increase productivity.

Moreover, stricter import regulations may need to be implemented to discourage the importation of non-essential goods that contribute significantly to the trade deficit.

Conclusion

In summary, the establishment of the India UAE Local Currency Settlement System has shown great potential in transforming economic relations and can serve as a model for similar bilateral arrangements with other trading partners.

By allowing direct settlement in INR and AED, it eliminates the need for an intermediary vehicle currency and reduces transaction costs. The successful execution of gold and oil transactions using this system demonstrates its ability to unlock greater trade and investment opportunities while promoting stability.

Although challenges remain, such as regulatory harmonization and liquidity management, the overall outlook is highly promising.

The India-UAE Local Currency Settlement system aligns with the Indian government’s policy stance of increasing the use of the rupee for global trade settlement. It sets a precedent for other countries seeking to de-dollarize their bilateral trade relationships, offering a pathway towards increased economic integration and reduced reliance on foreign currencies.

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